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Unformatted text preview: Suppose that the economy is already at the natural level of real GDP and that aggregate demand is projected to increase further, which will cause the AD curve in Figure 2 to shift from AD 1 to AD 2 . Figure 2 Combating inflation using contractionary fiscal policy As real GDP rises above its natural level, prices also rise, prompting an increase in wages and other resource prices and causing the SAS curve to shift from SAS 1 to SAS 2 . The end result is inflation of the price level from P 1 to P 3 , with no change in real GDP. The government can head off this inflation by engaging in a contractionary fiscal policy designed to reduce aggregate demand by enough to prevent the AD curve from shifting out to AD 2 . Again, the government needs only to decrease expenditures or increase taxes by a small amount because of the multiplier effects that such actions...
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